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Quantitative Easing? Welcome to Vegas!!

Posted by Larry Doyle on March 19, 2009 9:07 AM |

rolling-diceThe Federal Reserve has ZERO room to maneuver on its interest rate policy given the fact that its interest rate tool, the Fed Funds Rate, is currently set at 0-.25%. Could that rate be set at a negative level? Well, let’s just say that it has never happened with any central bank in the world. With no more arrows left in its interest rate quiver, what is a Federal Reserve to do to manage an economy? Let’s enter the world of “quantitative easing.”

Quantitative easing by any central bank is a policy in which that bank grows its balance sheet to purchase assets (government bonds, mortgage securities, government agency debentures, etc). The purpose of purchasing these assets is to drive the prices for these assets higher which in turn brings the interest rates on these assets lower (bond prices and interest rates on those bonds have an inverse relationship). The hope the Federal Reserve holds is that in bringing rates down (government rates and mortgage rates dropped by .3% to .5% yesterday) consumer and institutional demand for money will go higher and spur the economy in the process.

Wow! This sounds fairly easy. Why hasn’t the Fed utilized quantitative easing more aggressively prior to this? Well, the Fed already has employed a measure of quantitative easing starting late last year. The Fed purchased billions of the aforementioned securities. What happened? Did interest rates on these securities come down? Initially they did and then over the last few months they have moved higher. Why? Well, the demand employed by the Fed was offset by a lack of demand for these securities by foreign entities and domestic buyers. Was demand for credit by consumers and institutions sparked? Not really. Consumers and institutions remain very much in a delevering (paying down debt) mode as opposed to increasing debt obligations.

Should we expect a greater impact with this round of quantitative easing? Only time will tell.

If quantitative easing can move interest rates and equity markets by an order of magnitude of 2-4%, why not use more of this approach? Are there costs? Could quantitative easing be the magic bullet to save our economy? Is this the ultimate “money for nothing?”

In layman’s terms, I view quantitative easing as the equivalent of getting your room, meals, and drinks comped. However, every investor knows that for every perceived benefit there is a very real and actual cost. What are the costs of quantitative easing?

This policy will, in the future, massively grow the money supply in the economy. As the money supply grows, the value of that currency – that being our U.S. dollar – declines. The devaluation of our dollar is inflationary, but also a means to promote our exports. Make no mistake, the Fed and Treasury fully appreciate the risk of inflation but are willing to take that risk at this point.

The markets overnight have already reflected the fear of inflation and a lower dollar. The WSJ reports, Fed’s Move Sends Dollar Lower . Additionally, Oil Prices Jump on Weak Dollar

Welcome to Vegas!!

LD

  • kd

    Interesting timing…. This day in history, March 19, 1931, In an attempt to lift the state out of the hard times of the Great Depression, the Nevada state legislature votes to legalize gambling.

  • Larry Doyle

    Very interesting. I was not aware of that.

    Well, in so many words, the Fed and Treasury are looking for a hard 7 !!

    Thanks for sharing.

  • sunup

    If there was a lack of demand for these securities first time, should we expect a demand for the second round?.

    I’m utterly uninformed in these matters,(that’s why I try to follow along here)so a question. Does the Fed print more money to purchase these securities or acquire more debt from,say China?. Are they buying?, or am I totally of the mark?.

  • Larry Doyle

    The Treasury issues bonds which are purchased by the Fed. In that manner, the Fed is injecting money into the system. We grow our deficit in the process.

    The Chinese have shifted a lot of their purchase of our debt to very short term bills (3 mont bills, 6 month bills, 1 year bills).

    The rates that the Fed is trying to impact are longer maturities, primarily 10yr maturity. The hope is that by buying up these assets and bringing down rates, others (consumers, corporations, and institutions) will also borrow. We should not forget though that the increase in our deficit also has the effect of “crowding out” other borrowers from the market.

  • Larry Doyle

    Sunup…The Fed can also print money as well so that mechanism along with purchasing outstanding government debt serves to inject money into the economy.

  • getfitnow

    This may sound snide, LD, but is the FED too big to fail?

  • Larry Doyle

    Getfitnow…I guess it depends on how we define fail? If we see massive hyper-inflation in which our dollar loses significant value, could that be defined as failure?

    The Fed can leave the printing press and the money machine on all night and is now ratcheting up the speed button on that money machine.






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